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Webnote 227 AS+AD 1

section 2.2 AS +AD Webnote 227

Using AS + AD to understand the management of a macroeconomy

Webnote 227 AS+AD 2

Real GDP • Growth

• Employment

• National Income

0 gdp2 gdp 3

sras

ad

pl 1

Price Level (inflation/deflation/disinflation)

What can happen in the macro economy? 4 alternatives. see webnote 328 (recessionary gap) Read Blink

pp 193-194

gdp 1

Cost Push: economy shrinks (toward gdp 2) due to higher costs

Demand Pull: economy grows(toward gdp 3)due to higher spending: C+I+G+X-M

Recession/deflation: economy shrinks (toward gdp 2) due to falls in spending: C+I+G+X-M

Supply Side Growth (at lower price level): economy grows (toward gdp 3) due to supply side policies that will impact LRAS shifting it from LRAS 1 to LRAS 2

YFE 1

Lras 1 Lras 2

YFE 2

What cause a shift in AS?

Webnote 227 AS+AD 3

SRAS LRAS

1.  WAGE RATES: rise or fall 2.  RAW MATERIALS: costs of

inputs rise or fall (e.g. oil) 3.  IMPORTS- rising import

prices cause sras to shift from sras 1 to sras 2.

4.  TAXES+SUBSIDIES: both affect ability of firms to produce

1.  Changes in Q + Q of capital investment

2.  Changes in Q + Q of labour

Supply side policies - see webnote 261 to understand how to shift LRAS

Webnote 227 AS+AD 4

Diagram A: Aggregate Demand / Aggregate Supply Model in the Short Run

§  AS-AD to Manage economic objectives

Price Level (inflation,

deflation,

disinflation)


• Employment


gdp2 gdp 3

sras 1

sras 2

ad2 ad1

pl2

pl3 x

y

z pl1

gdp 1

Change in PL= movement

Changes in c,i,g,x and m = shift

s

See Webnote 221

Webnote 227 AS+AD 5

Diagram B: Aggregate Demand / Aggregate Supply Model in the Short Run



• Employment


gdp2 gdp 3

sras 1

sras 2

ad2 ad1

pl 2

pl 3

x

y

z pl 1

gdp 1

ad3

w

v

u

r

s

t

pl 4

sras 3 Price Level

(inflation/deflation/disinflation) pl

Gdp 3

4 outcomes

See webnote

See Webnote 222

Webnote 227 AS+AD 6

What causes a movement in AD? Ad(expenditure) = c + i + g + (x-m)

§  AD downward sloping as like the micro demand curve (see intro webnote 110)

§  AD inversely related to PL:

price level gdp

Why does ad slope downwards? See slide 16

Price level

Real gdp

Aggregate demand

PL 2

PL 1 a

b

0

Webnote 227 AS+AD 7

What causes a Shift in AD?

1.  Fiscal policy-e.g. + or – in direct taxes

2.  Monetary policy- +or- in interest rates

3.  Foreign income changes 4.  Expectations www.ifo.de 5.  External (outside economy)

shocks - oil gdp 1 gdp2

ad1

ad2 pl

Webnote 227 AS+AD 8

What causes a Shift in AD? example §  Fiscal policy: example of how it affects

AD §  Government intends to leak the economy

because of a fear of inflationary pressure Price level

Real gdp 0

ad1

ad2

Government raises direct taxes on income to reduce disposable income. Spending by consumers © falls: AD 1 AD2

Price level falls and gdp declines!

How will economy be affected? We can only fully see when we insert AS.

Webnote 227 AS+AD 9



• Employment


0 gdp1 Gdp 2

sras 1 ad2

ad1

pl 1

Pl 2 x

y

Price Level (inflation/deflation/disinflation) pl

gdp

4 outcomes

What causes a Shift in AD? example

Solution: The economic objective here

is to inject spending into the

macroeconomy and sometimes

government may need to intervene to

grow the economy (Keynesian)

shifting AD back to ad 2 or allow the

lower wage rates that might result

from the recession to shift SRAS

downwards to SRAS 2.

Recession (2 consequetive quarters of declining growth). Economy shifts from Y to X and spending falls so that national income changes from gdp 2 to gdp 1 C + I fall creating unemployment / slack in the economy and price level adjust to pl1.

sras 2

Webnote 227 AS+AD 10

Points to note about AD 1.  AD downward sloping as the micro demand curve

( refer to real balance, interest rate and net export effects see last slide on this presentation)

2.  AD inversely related to PL + shows the PLANNED level of spending at different price levels by H, F, G and Trade sector.

3.  AD represents spending of consumers (H), investors (I) ,government (G), and foreigners (X-M).

4.  Govt. policy should therefore attempt to control AD to ensure equilibrium in the economy i.e. growth + stable prices.

5.  WhatinfluencesConsumption? 6.  Live Link see UTUBE 2.2 clip 5 Consumption and AD 8/10

What influences Investment? See web 313 (syllabus 2.5) for 4 influences on Investment (I)


AS (aggregate supply)

sras



• Employment



§  Represents total output in an economy §  OR §  Total supply of labour in the

macroeconomy. §  Therefore it can be used to show a

‘final goods’ view or a ‘labour’ view of the economy

Aggregate supply (AS)of final goods or labour in a whole economy


What causes AS to shift ?

1.  Changes in Q + Q of capital investment 2.  Changes in Q + Q of labour Supply side policies - see webnote 261 shows how government policies can cause output to change

sras 2

sras1

Price level

Real gdp 0 gdp1 gdp2

Pl 1

Pl 2 Without a change in the price level 1-5 could shift AS


Key Points about LRAS §  Features: §  Shape of LRAS curve is disputed see Keynes vs Monetarists (neo classical school, or supply siders) §  The key issue amongst economists is the shape of the AS. To what extent does it take a vertical shape ? It is this vertical

trend which leads to inflationary pressure §  Alternative interpretations exist as to the shape §  The key issue is at which point the economy is currently operating §  Some sources draw the Keynesian LRAS at a point below yfe indicated below See Cambridge/Tragakes book p 246. The

only conclusion to draw from this is that unemployment rate at this point is zero or 0% whereby all resources in the economy are used. The neo classical economists on the other hand see that at yfe the economy is at full employment with an unemployment rate of 4-6%. This is what the monetarists described as the natural rate of unemployment. Keynesian theory does not account for a ‘natural’ unemployment rate and therefore the conclusion is that the rate of unemployment at the full employment level = 0%. Both of these alternatives are referred to as full employment.

: see UTUBE 2.2 “Keynesian vs Monetarist on the LRAS” . Rating: 6/10

Price level

Real gdp

Lras1 Lras 2 Lras 3

0

ad1 ad2 ad3

ad4

ad6

ad5 ad7

ad8

ad9

yfe yfe yfe 0% unemployment at keynesian yfe 4-6% unemployment at neo classical yfe

Lras 1 = keynesian Lras 2 = neo classical Lras 3 = keynesian


Points about LRAS Features: §  Shape of LRAS curve is disputed see Keynes vs Monetarists §  The key issue amongst economists is the shape of the LRAS. To what

extent does it take a vertical shape ? It is this vertical trend which leads to inflationary pressure

§  Alternative interpretations exist as to the shape: you must know these! §  The key issue is at which point the economy is currently operating. See

gdp Y on slide 3 see UTUBE 2.2 Episode 25 “Macroeconomic Viewpoints” . Rating: 8/10

Price level

Real gdp

Lras 1

Lras 2

Lras 3

0

‘slack’

capacity capacity capacity

‘slack’ ‘scarcity’

yfe yfe

Note: When drawing Keynesian LRAS use LRAS 3


How to manage an economy?

• AS /AD model allows analysis of the macro economy • Shape of LRAS is disputed

• Behavioural factors represented in by statistical indices such as a business confidence index plays a vital role in any economy and model

expectations can often be unfulfilled

Y

C i g x m

C.C.

Y

N.I.

Economy slowing

Direct taxes fall

C.C. Example:

Example:

Example:

Example:

A




• Employment


0 gdp2 gdp 3

sras ad

ad1

pl 1

pl 2


pl

gdp

4 outcomes

In (de) flationary Gap see webnote 328 (recessionary gap)

Lras 1

yfe 1

Lras 2 Lras 3

pl 3

Read Blink pp 193-194

yfe 2 yfe 3 gdp 1



• Employment


0 gdp2 gdp 3

sras ad

ad1

pl 1

pl 2


In (de) flationary Gap see webnote 328 (recessionary gap)

Lras 1

yfe 1

Lras 2 Lras 3

pl 3

Read Blink pp 193-194

Note: yfe changes according to the shifts in the LRAS

yfe 2 yfe 3

gdp 1

What allows gdp 1 to occur when full employment = yfe2?

Ans: Natural rate where labour is available to produce over the capacity level. In this case the capacity is YFE 2

Inflationary gap (from Lras 1)

Deflationary gap (from Lras 3)


Price level

Real gdp

Lras1

Lras 3

0

ad1 ad2 ad3

ad4

ad7

ad8

ad9

In (de) flationary Gap see webnote 328

§  Keynesian concept

deflationary pressure “Bust”

yfe

inflationary pressure “Boom”

yfe

webnote 220 Big Ideas

20

In (de) flationary Gap §  Keynes Friedman §  “market unstable in LR” “market stable” in LR

yfe 2 yfe 3

lras 1 ad

ad1 lras 3

Keynes believed the economy could be at a non yfe equilibrium for long periods of time i.e. gdp2 and would not adjust to fye without government intervention

Friedman believed that the economy was largely self adjusting and would return automatically to yfe 3

See webnote

306

gdp 2

ad2 sras 2

sras 3 ad sras 1


Short run vs long run 1.  Macroeconomic Short Run: prices of final goods change but not

factor prices. There is a time lag. ( time lag is a delay period of time between an action and a response)

2.  Macroeconomic Long Run: prices of goods include the changes to factor prices i.e. costs of factors of production increase

Do firms want ZERO inflation? No, not really! Firms like stable (1-2%) inflation as they see total revenues rising but workers are not asking for higher wages in the short run i.e. factor costs not rising in short run. This gives firms the opportunity to raise prices ( sometimes above the cost increases and therefore raise revenues in turn raising profits)


exam focus

§  SL paper 1 2010-May §  2a Aggregate demand consists of

consumption, investment, government spending and net exports (exports – imports). Explain two factors that may influence investment and two factors that may influence net exports.

§  2b Evaluate the effectiveness of and increase in investment expenditure on the performance of an economy.

§  15/25


Bib to read:

§  Blink chapters 14 +15 §  Triple A + Tutor2U+ BIZED §  A.G.Anderton 108-115 §  Economic Review:Akos Valentinyi, "Monetary

policy and interest rates", 20(4), April 2003 §  Economic Review: Peter Smith, "Growth and

the government", Question and Answer 19(3), February 2002


HL


HL Keynesian Multiplier- see syllabus item 91 see webnotes 314 and 323 see webnote 703 for examples

1 1 1 – MPC = MPS + MPT + MPM 1.  Keynesian multiplier justified G spending 2.  mpc >1 3.  100 m injection (J) would result in a > 100

m increase in N.I.


Why is AD negatively sloped? (movement along ad see syllabus item 82) note: 1 to 3 below are for a rising price level i.e. inflation. What is movement effect of a changing price level. This movement is explained by 1-3 below.

1.  wealth effect or “real balance”/ savings effect: rising prices reduces the real value of bank deposits. When people feel poorer then they tend to spend less i.e. AD falls as PL rises. Rising prices tends to make people feel poorer. Then AD falls. Note: when prices rise the value of bank balances fall

2.  “net export” effect (X-M): rising price level in the domestic economy makes exports more expensive and imports more attractive i.e. AD falls as PL rises because of foreign trade sector: X-M

3.  “interest rate” effect: if price level rises interest rates for borrowing from banks may be likely to rise over time as government intervene to reduce spending. Interest rates rise and therefore money will become more expensive causing spending ( C+I ) to fall over time i.e. AD falls as PL rises.

Note: Business and Consumer Confidence is also a factor to consider. Confidence

rises then spending rises. Confidence falls then spending falls.

Rising price level: ad

Falling price level: ad inverse relationship

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